Good morning, ladies and gentlemen, and welcome to the MSC Reports Fiscal 2018 4th Quarter and Full Year Conference Call. All participants will be in a listen only mode. Please note, today's event is being recorded. This time, I'd like to turn the conference call over to Mr. John Corona, Vice President of Investor Relations and Treasurer.
Sir, please go ahead.
Thank you, Jamie, and good morning, everyone. I'd like to welcome you to our fiscal 2018 Q4 conference call. In the room with me are Eric Gershwin, our Chief Executive Officer and Rustom Jila, our Chief Financial Officer. During today's call, we will refer to various financial and management data in the presentation slides that accompany our comments as well as our operational statistics, both of which can be found on the Investor Relations section of our website. Let me reference our Safe Harbor statement under the Private Securities Litigation Reform Act of 1995.
Our comments on this call as well as the supplemental information we are providing on the website contain forward looking statements within the meaning of the U. S. Securities laws, including guidance about expected future results, expectations regarding our ability to gain market share, and expected benefits from our investment and strategic plans, including expected benefits from recent acquisitions. These forward looking statements involve risks and uncertainties that could cause actual results to differ materially from those anticipated by these statements. Information about these risks is noted in our earnings press release and the Risk Factors and the MD and A sections of our latest Annual Report on Form 10 ks filed with the SEC as well as in our other SEC filings.
These forward looking statements are based on our current expectations and the company assumes no obligation to update these statements. Investors are cautioned not to place undue reliance on these forward looking statements. In addition, during the course of this call, we may refer to certain adjusted financial results, which are non GAAP measures. Please refer to the GAAP versus non GAAP reconciliations in our presentation, which contain the reconciliation of the adjusted financial measures to the most directly comparable GAAP measures. I'll now turn the call over to Eric.
Thank you, John. Good morning, everybody, and thanks for joining us today. As we've now completed fiscal 2018 and launched into fiscal 2019, I'd like to begin this call with the state of the company and offer some perspective on our progress. From there, I'll provide more specifics about the environment and our recent performance. I'll then turn it over to Rustom, who will review the details of the fiscal Q4 and our full year.
He'll provide our Q1 guidance and also our fiscal 2019 annual operating margin framework. I'll briefly wrap up before we open up the line for questions. Over the past several years, we have repositioned MSC from a spot buy supplier to a mission critical partner on manufacturing plant floors across North America. We have done so by focusing on products and services that are technical and high touch. We have cemented our leadership in our core business of metalworking.
We've gained solid traction in the Class C VMI space and established a new platform in OEM fasteners through our acquisition of AIS. At the same time, we've built upon our success in inventory management channels by continued expansion of vending and VMI. The last leg of this journey was to redesign our sales force to better serve our customers as a mission critical partner. We've migrated our sales force from one designed to sell a spot buy value proposition to one that is prepared to deliver upon the new, more complex and high touch role that we play for our customers, enabling them to achieve higher levels of growth, productivity and profitability. This was the work that was completed during fiscal 2018.
As we implemented these changes, our organic growth rate underperformed due to account transitions, sales rep transitions into new roles and declining sales headcount as we made the migration. As we begin fiscal 2019, this work is behind us. Our sales team is settling into new roles and we're back to more typical levels of execution and customer focus in the field. And I'm encouraged by recent signs of progress. For example, our test pilot market continued its strong performance and momentum is building across the broader company, particularly in important areas of our business such as core customers.
And while we don't expect to return to historical growth rates right away, we are seeing the progress that we expected. Returning to fiscal 2018, while organic revenue growth underperformed, we executed well across other dimensions. We continued delivering gross margin stability in the face of a fiercely competitive environment. In fact, excluding the impact of acquisitions, gross margins were flat with fiscal 2017. We achieved a roughly 70 basis point improvement in operating expense leverage as a result of our continued focus on productivity.
Our 2 acquisitions performed well with Deco continuing to exceed our initial expectations and AIS off to a solid start. Overall, there is a sense of excitement here about our direction and momentum. Turning now to our fiscal Q4, it was a microcosm of the full year with sales growth slightly above the midpoint of our guidance range, gross margins at the top end of our guidance range and earnings per share $0.02 above the midpoint of our guidance. I'll now turn to the environment. Conditions in the U.
S. Industrial market remain strong. While sentiment indices such as the MDI have moderated a bit in recent months, they remain at high levels. The MDI was 55.8 in July and 58.1 in August. Adding the September reading of 57.1 brings the rolling 12 month average to 58.0 pointing to continued growth in metalworking end markets.
This is also reflected in customer order volumes and general industry sentiment. Last month, we attended IMTS, which is North America's largest manufacturing show. It occurs every 2 years in Chicago and it's a great chance for us to catch up with customers, suppliers and other important industry participants. The energy, attendance levels and outlook for continued strong conditions were all high. One uncertainty is of course the tariff situation and it's on everyone's mind.
So with respect to MSC, let me frame for you our exposure to Chinese sources of supply. First, we have goods that we import from China directly ourselves. For example, some of our exclusive brands where MSC is responsible for paying any related tariffs. This exposure is only about 5% of our cost of goods and we expect the tariff impact to be passed along. Then we have products from suppliers that either import directly from China or from countries of multiple origins where one of those countries is China.
And this indirect exposure amounts to just above 5%. So put together, direct and indirect exposure comprise slightly more than 10% of our cost of goods sold. Of this pool of products, less than half are on the current tariffs list, making our exposure to cost increases at under 5% of our total cost of goods. What we've not captured here, as it would be nearly impossible to do so, are those goods from suppliers that may contain sub components from China. Even so, it's fair to say that our exposure to China is low and it will almost certainly decline as supply chains and sourcing adjust to the impact of tariffs.
Keep in mind that many of our suppliers have manufacturing operations in multiple countries and we ourselves source from many different domestic and multinational suppliers. So there is some flexibility in the supply chain. And with our extensive offering of numerous brands, we can give our customers many alternatives to products sourced from China. While it's still early to draw definitive conclusions about the impact of tariffs, let's talk about some likely outcomes. In addition to higher costs from China, suppliers who produce in other countries will likely see growing demand and input cost pressures that could lead to price increases on their products.
Together, this will likely result in list price increases from manufacturers, which we would expect to pass along in the form of our price increases. If this materializes, tariffs would likely stimulate inflation across the broader economy and this would be a positive for us as long as demand trends hold and we achieve historic levels of price realization. Returning now to the fiscal Q4, the pricing environment remained relatively stable. We implemented a modest summer price increase during the Q4, which averaged about 1.5%. As we mentioned on the last call, the number of suppliers that raised their list prices since our January mid year price increase was more limited than the inflation headlines would have suggested.
Price realization though remained positive during our Q4.
I'll turn now to our revenue performance
in the quarter. Sales growth came in slightly above the midpoint of our guidance range. While that alone is not particularly noteworthy, several changes in trend under the surface have us encouraged. First, we expect growth in the base business to improve from the 4th quarter at 4.5% to 5.5% at the midpoint of first quarter guidance. 2nd, our core customers.
For most of last year, the mid single digit growth in core lagged the company growth rate. We saw a noticeable uptick though in August September where core growth was in the high single digits. This is particularly noteworthy because it is primarily core where our sales effectiveness changes were aimed. The 3rd encouraging sign, national accounts, where high single digit growth continued. We're encouraged by new account activity, which is ramping along with the other changes in sales and bodes well for future growth prospects.
The one trend that was not positive was government. Government growth was down mid single digits in the 4th quarter and mid teens thus far in the Q1 of 2019. This was due to a slower rate of government year end spend along with the additional impact of a couple of recent contract losses. The developments in government are muting the improvement that we're seeing in the rest of the business. We have taken swift actions to correct the issues in government, but I do expect it to remain a headwind over the next couple of quarters.
The 4th encouraging sign is growth in our smallest accounts represented by our direct marketing channel. As we have reengineered our sales model, we've done the same with our direct marketing channel, putting more resources behind it and transforming it to be less transactional and more relationship and loyalty based. Combined with the benefits of web pricing, these changes are translating into results. During our Q4, the direct marketing channel grew double digits. That momentum extended into September with direct marketing up in the mid teens.
While representing less than 10% of sales, we view this as another encouraging sign as an indication that we can bring our new value proposition to life even without a live person in the right sized accounts. Rounding out the results of our fiscal Q4, sales to vending customers contributed roughly 200 basis points to growth and our net salable SKU count was nearly 1,650,000 up from last quarter by roughly 40,000. Given the success of our SKU expansion program, we accelerated it in our fiscal Q4 and this should positively impact sales growth as we move through the year. Turning to sales headcount, we mentioned on our last two calls that we had opened up our recruiting funnel and we're pleased with what was a strong recruiting effort in the 4th quarter. And as a result, we added a net 35 salespeople.
You'll also see in our operating statistics posted on the website that we made a slight change to the field sales and service definition. As we completed the sales effectiveness changes, we thought it was a good time to reassess our definition, which now includes any associate who is in our customer's facility providing a sales or service function. As a result, headcount numbers changed slightly and we've restated historical data accordingly. You'll see though that it's not changed the historic trends. Looking forward, we expect to add somewhere in the neighborhood of 50 sales associates across the balance of the fiscal year.
Of course, this could move up or down based upon the environment and the performance that we're seeing out of our new reps. I'll now turn it over to Wissam.
Thank you, Eric. Good morning, everyone. Before getting into details, let me remind you that we had provided Q4 guidance for both our total company results and for our base business, which is total company excluding acquisitions. For the Q4, our total average daily sales were 13,100,000 dollars an increase of 9.5% versus the same quarter last year. Deco and AIS between them contributed 500 basis points of acquisitive growth and base business growth was 4.5%.
Our reported gross margin was 42.9% for the quarter at the top of our guidance range and down 130 basis points from last year with roughly 100 basis points of this coming from the acquisitions. Excluding these acquisitions from both periods, our gross margin was 44.3%, down roughly 30 basis points. In Q4, the lagged impact of product cost increases from earlier in the year exceeded the benefits of higher realized pricing and supplier rebates. We still ended fiscal 2018 with base business gross margin essentially flat with the prior year, but until our next price increase, which will likely be during our fiscal Q2, the net impact of price and cost should be a slight headwind. And you will see this reflected in our fiscal 2019 Q1 guidance.
We continue to drive productivity in Q4 with OpEx to sales reduced 90 basis points from last year to 30.1%. Total OpEx was $252,000,000 up $18,000,000 from last Q4 with about half of this increase coming from the acquired businesses. Of the base business year on year increase, roughly $5,000,000 is attributable to volume related variable costs, such as pick pack, ship, freight and commissions. The balance is mostly from personnel related costs and investments. Base business OpEx to sales improved to 30.6%, roughly 50 basis points below last year's Q4.
So once again, productivity and cost controls offset much of our investment spending and general inflation increases. Our fiscal 4th quarter operating margin was 12.9%. It's worth mentioning that we incurred $3,200,000 of AIS acquisition costs and purchase accounting charges required to amortize the stepped up value of acquired inventory. This pulled our operating margin down by roughly 40 basis points. Our base business operating margin was 13.8%, a 30 basis point improvement on the comparable results in the same quarter a year ago as we leveraged our OpEx.
Inclusive of the impact of the Tax Cuts and Jobs Act, our total tax expense on a percentage basis for the Q4 was 29.6 percent in line with guidance. All of this resulted in reported earnings of $1.29 per share, dollars 0.02 above the midpoint of guidance. This included $0.03 of dilution from acquisitions as essentially comprised of AIS acquisition costs and purchase accounting charges. And in Q2, due to the Tax Cuts and Jobs Act, we had a one time net EPS benefit of $0.72 from the revaluation of tax related balance sheet items. In Q4, as we completed the year end true up of that balance sheet revaluation, the impact was a $0.01 negative reduction taking the full year benefit to $0.71 Now turning to balance sheet.
Our DSO was 56 days flat with our fiscal Q3. Our inventory increased slightly during the quarter to $518,000,000 that's up $6,000,000 from Q3 and base business inventory turns remained sequentially flat at 3.5x. Looking ahead to the Q1, we expect inventory to continue to increase as we protect against possible supply chain disruption and also by ahead of expected price increases. Net cash provided by operating activities in the Q4 was $109,000,000 versus $88,000,000 last year. The main driver was a $12,000,000 increase in net income.
Our capital expenditures in the 4th quarter were $14,000,000 and after subtracting capital expenditures from net cash provided by operating activities, our free cash flow was $95,000,000 dollars That compares to $79,000,000 in last year's Q4. We also bought back 680,000 shares for $57,000,000 during the quarter. Our fiscal 2018 free cash flow generation was very strong with $295,000,000 generated versus $200,000,000 last year. We ended fiscal 2018 with capital expenditures of $45,000,000 that's relatively flat versus fiscal 2017's $47,000,000 dollars and most of the year on year improvement is attributable to higher operating profits, lower cash taxes paid and lower uses of cash for working capital. We use the strong free cash flow to pursue our balanced but opportunistic capital allocation philosophy.
We spent $88,000,000 on the acquisition of AIS versus the $42,000,000 acquisition spend in the prior year, dollars 82,000,000 in buying back 972,000 shares versus $49,000,000 for 685,000 shares in fiscal 2017 and we also increased our ordinary dividends by 23 percent paying out $125,000,000 versus $102,000,000 in the prior year. We still ended the fiscal year with a $28,000,000 reduction in our net debt, going from $517,000,000 to $489,000,000 and our leverage ratio also declined slightly over the year ending fiscal 2018 at one times, so we continue to have significant balance sheet capacity. Our total debt as of year end was $535,000,000 comprised mainly of a 2 $24,000,000 balance on our revolving credit facility and $285,000,000 of long term fixed rate borrowing. We also ended the year with $46,000,000 in cash and cash equivalents. Before turning to our Q1 guidance, let me briefly cover our full year P and L performance.
Revenue rose 11% or $316,000,000 with $178,000,000 of this growth being organic. We maintained our base business gross margin at 44.6 percent in a tough environment and improved our total company OpEx to sales ratio by 100 basis points in fiscal 2018. Our continued focus on productivity and reducing our cost to serve helped to offset inflation and helped to fund investments. Due to acquisitions, our total MSC operating margin remained flat at 13.1%. However, our base business operating margin rose by 50 basis points from 13.2% to 13.7% and our operating profit grew by almost 11%.
All of this resulted in a base business incremental margin of 23% for the year. So now let's move to guidance for the Q1 of fiscal 2019, which you can see on Slide 6 and it's shown with and without acquisitions. Now that Deco is in the base, it is only the AIS business that is included in acquisitions. We expect total company ADS to increase by 6 point 8% to 8.8% versus the prior year period. This includes 4.5% to 6.5% of organic growth and around 2 30 basis points from AIS.
Our Q1 total gross margin is expected to be 43% plus or minus 20 basis points. That's up 10 basis points sequentially and down 60 basis points year over year. Roughly half of the year over year decline is due to AIS. As I noted when discussing our Q4 base business gross margins, supplier cost increases will be a slight headwind until we put through a mid year price increase in our fiscal Q2. And while price realization remains positive, it will not fully offset expected cost increases in Q1.
Our operating expenses are expected to be around 254,000,000 dollars up $18,000,000 over last year's Q1, with the acquired AIS business accounting for roughly $5,000,000 of this. Variable expenses associated with higher base business sales account for roughly $4,000,000 the remainder comes another roughly $4,000,000 the remainder comes mostly from inflation net of productivity, investment spending like our increased field sales and service headcount as well as our stepped up direct marketing programs. We're also incurring just under $1,000,000 of severance costs this quarter that will not repeat. However, even after absorbing all of these, our expected OpEx to sales ratio in Q1 is unchanged from the prior year's Q1. Sequentially, our OpEx is expected to be up about $3,000,000 after allowing for volume movement.
And again, this is primarily attributable to the increased field sales and service headcount, the stepped up marketing and the severance costs. We expect the first quarter's operating margin to be approximately 12.3% to the midpoint of guidance, a 60 basis point decline over last year's 12.9%, almost half was due to AIS with the remaining roughly 30 basis points coming from the year on year gross margin decline. Our productivity journey continues, but the difference this quarter comes from the impact of specific decisions. First, sales force expansion. While this has been telegraphed for a while, we saw a larger step up in sales headcount than we're like in Q1 we are likely to see in the next couple of quarters.
2nd, the increase in direct marketing because of the strong growth we are seeing. 3rd, the severance costs, which will offer future cost savings. All of these actions are to support growth and organizational alignment with our plan. While these actions may impact our reported operating leverage, The fact is that our productivity initiatives are still going strong and we will continue to pay future dividends. Turning to our estimated tax rate for the Q1, it is 25.2%, in line with what we said in January.
Our guidance also assumes that our weighted average diluted share count declines to roughly 55,900,000. Our fiscal 2019 Q1 EPS guidance range is $1.28 to 1 $0.34 dollars Note that this is after absorbing $0.01 of dilution from our fiscal 2019 annual operating margin framework. As a reminder, this annual framework is our attempt at helping you understand how our business is likely to perform under various macro environments with our specific initiatives also baked in. Given the short cycle nature of our business providing guidance beyond the quarter is extremely difficult. We also realize that individual quarters have swings and outliers in both directions.
So this framework allows you to choose the likely macro environment affecting both demand and pricing and then see how our business will likely perform over the course of the year. Like last year, we are providing potential annual growth rate scenarios on the horizontal axis. However, we are making a change to the vertical axis of our framework, moving from the price environment for the year to annual gross margin scenarios. We're doing this to provide greater clarity. Again, this is the 2 by 2 matrix that you see on Slide 7 and 8, the first for the base business excluding AIS and the second for the total company.
Now with respect to the gross margin access, the big driver that will determine whether we fall into the contraction or expansion scenarios is pricing. If the tariffs stimulate inflation in the form of broad based manufacturer list price increases, then we likely move into the expansion scenario, assuming historic levels of price realization. If tariffs do not stimulate broad based list price increases, we like to move in the contraction scenario. This is because we will face cost increases as the calendar 2018 supplier price increases move work their way through our P and L. As you can see also as you can see, we're anchoring the framework on where we are guiding Q1 gross margins as this represents our most current data points.
In both the base and total company frameworks, the contraction scenario assumes that price realization is insufficient to offset the impact of inflation and mix. Conversely, the expansion scenario assumes that we realize price at a level sufficient to more than offset cost inflation and mix. Now moving to frameworks themselves. For the base business, as you see on Slide 7, the moderate growth scenario is for 4% to 8% ADS growth and our strong growth scenario has an ADS range of 8% to 12%. For the base business, our gross margin range in the contraction scenario is 42.5 percent to 43.3 percent, while it's 43.3% 44.1% in the expansion scenario.
Our base business operating margins under these scenarios range from 13.2% to 14.4% with an average of 13.8%. Now to the total company framework. As you see on Slide 8, AIS is expected to add roughly 150 basis points to our ADS growth. So the moderate growth scenario range is from 5.5% to 9.5% and our strong growth scenario range is from 9.5% to 13.5%. In the total company framework, our gross margin range in the contraction case is 42.3% to 43.1%, while it is 43.1% to 43.9% in the expansion case.
Including AIS reduces operating margins by about 20 to 30 basis points in each quadrant. Therefore, they range from 12.9% to 14.2% with an average of 13.5%. Stepping back, as you can see from our framework, in 3 of the 4 quadrants, base business operating margins would likely expand over fiscal year 2018. The scenario in which they likely would not expand is the lower left quadrant. That would happen if revenue growth does not improve from current levels and if gross margin contracts from here, which means we do not see broad based price inflation.
In 2 quadrants, we will achieve 20% incremental margins. The drivers getting there would once again be pricing. If we see broad based pricing, we like to hit 20%. If we do not, it will be difficult to reach. I'll now turn it back to Eric.
Thank you, Rustom. As you've heard me say many times, technical expertise is an important element of our competitive advantage. And one way this manifests itself is in documented customer cost savings. We delivered roughly $400,000,000 in documented cost savings to our customers in fiscal 2017, and I'm happy to share that we did the same in fiscal 2018, delivering another 400,000,000 dollars These savings represent meaningful productivity gains for our customers. There's another equally important though element of our competitive advantage and that's our high touch customer service culture.
Put simply, every single associate in our company puts the customer first. So before I close, I want to share a quick example that brings this to life. A couple of weeks ago on a Sunday, an important Midwest based customer that manufactures Marine Engines called their MSC salesperson early in the afternoon desperately needing help to keep their shop floor running. They had an important job to get out by the end of the next day, but were in need of a pretty obscure part that if not in hand would cease production. Our team mobilized within 20 minutes of the call and by 5 pm we had opened up one of our warehouses, found the part and shipped it.
It arrived at the customer's dock first thing Monday morning, ensuring that they meet their production deadline. Our role with our customer was bigger than next day availability. We helped them get a critical job out the door and in doing so help them satisfy their customer. Examples like this happen all the time across our company and speak to our entire team's dedication to our customers and to our mission. We'll now open up the lines for questions.
And our first question today comes from Hamzah Mazari from Macquarie. Please go ahead with your question.
Hi, this is actually Mario Cortellacci filling in for Hamza. So if I heard correctly, it sounds like you guys plan on passing through your cost increases that are due to the tariffs. Just want to clarify, I guess, do you plan on passing through those price increases to cover 100% of the increase? And do you think there will be any lag in this process? And maybe you can provide any color on how those conversations are going with clients?
Yes. Mario, it's Eric. So look, the short answer is yes. We plan on passing along all of the MSC pays the tariff, where we're doing direct importing and an indirect effect. NSC pays the tariff where we're doing direct importing and an indirect effect from suppliers who are doing the importing.
What I would say is, it's still relatively early. So as it relates to the direct effect where MSC is directly affected by a tariff, we are passing that along. We are doing so right away and do expect to recoup all of the costs. With respect to the indirect, what I would say is, as I mentioned, it is still early. So while there have been some select suppliers that have moved, most have not yet.
And that really speaks to the timing lag that Rustom talked about earlier as it relates to gross margin, where we are beginning to realize through our P and L right now cost increases from earlier in the year, many of these price increases that we likely expect to see have not yet happened and would most likely occur in the form of the manufacturer who makes lots of parts and the inputs may only be a portion of the final product, that this would likely make its way through to the market in the form of a list price increase. Our expectation would be like in a typical year that would occur early in calendar, meaning January 2019 where we see the bolt. So I would anticipate over the next month or 2, we're going to have a lot more discussions.
Great. And maybe you can also comment on how you think about your headcount growth longer term given the current demand environment. Maybe you can touch on any existing capacity within your sales force as you guys approach your new sales force strategy.
Yes, sure, Mario. So, look, the first thing I'll say is and hopefully you could tell by the tone, I am encouraged by the progress that we're seeing under the covers in terms of the sales effectiveness changes taking root, particularly with what we're seeing in the trends in the core business, which is an important part of the business for us. It's one that's lagged and is starting to pick up momentum. So I think that's speaking to progress being made. As it relates to look, the whole rationale behind these changes was to move the sales force in keeping with the strategy and to create a more efficient model so that over time we expect to add headcount, but not at the rates that we have been adding in the historical formula.
What you saw from the Q4 to the Q1, quite frankly, was the result of a really strong recruiting effort. We have plans and projections and then there is the reality that hiring is not a precise science and you never know exactly how many are going to translate in 1 quarter. So that plus 35 from Q4 to Q1 is a bigger step up than you're likely to see from us for the balance of the fiscal year, with the one caveat being what you mentioned, which is there's sort of 2 variables that we would look at to assess whether we I had shared from here on out somewhere in the neighborhood of plus 50 over the remaining three quarters, that could move up or down based on 2 variables, one being the environment, as you mentioned, the second being the performance of the new reps under the new model, meaning if we really like what we're seeing in terms of performance, we could potentially move that up.
Great. Thank you so much.
Our next question comes from Evelyn Chow from Goldman Sachs. Please go ahead with your question.
Good morning, guys.
Hi, Evelyn.
Maybe just touching upon your expected price increase in fiscal 2Q. I understand that some of your suppliers have yet to sort of take incremental price actions thus far to calendar year end. But what are the potential prospects we're seeing an earlier than expected price increase? And also with the 25% step up in mind on Jan 1, would the magnitude of that price increase for your business perhaps exceed the 1.5 points you put up this quarter?
So Evelyn, look, I think as we the closer we get to year end here, the less likely it is, although possible that our pricing action would precede Jan 1, it's possible. So it could happen even earlier in Q2, meaning December. It would really be a function of what happens with our manufacturers. As you've heard me say now, excuse me, by the way, struggling with this little northeast cold here. But as you've heard me say, the inflation has been slower to move than I would have expected.
I will tell you that there's a lot of discussion occurring obviously because of the tariffs. So we are expecting there to be meaningful supplier movement, but we'll see. I mean, I think the next 1 to 2 months are going to really bear it out. Then obviously, the next key will be once we take an increase, which we would expect to, how we do on realization. And look, the environment right now is becoming more and more ripe for achieving solid levels of realization because certainly all suppliers, all customers are talking about input costs rising.
Makes sense, Eric. And then turning to the government declines, could you just elaborate on the nature of the contract losses? And maybe give us some insight into the actions you're taking to recover this business and the line of sight into doing so in the next couple of quarters?
Yes, sure, sure, Evelyn. So, the government so our government business, which we've described as in the neighborhood of 10% of sales, is made up of a lot of contracts across a lot of different entities in the government. So it's pretty well diversified and spread out across this entity called government. The contracts generally are multiyear terms with renewals at varying dates. And over time here and there we lose 1.
Generally, we've done well in government and we win more than we lose. But just recently and the reason I called it out, we lost a couple, which is not a usual event for us. And it's why you saw the growth rate I mentioned and wanted to flag the growth rate in Q1 stepping down from Q4. We made a couple of adjustments. To be perfectly frank, to mitigate some of this headwind and recapture to mitigate some of this headwind and recapture share there.
So what I described is I think we'll probably see government as a headwind for the next couple of quarters. But if some of these countermeasures do their job that it would lessen.
Great. And then finally, one last quick clarification from my end. Just on AIS and that impact to gross margins in 1Q, could you go into a little more detail as to what you're seeing there? Because I thought that inventory step up was probably supposed to roll off from 4Q to 1Q.
Yes, the inventory step up has the amortization, Evelyn, that's finished. I mean, that took place in the Q4. What you're seeing is just fundamentally the impact of AIS being a business that comes in at a much lower gross profit gross margin number than MSCs. I mean the gross margin is in the mid-30s basically with in the low to mid-30s.
Understood, Rustom. Thanks guys and feel better, Eric.
Thank you, everyone.
Our next question comes from Ryan Merkel from William Blair.
So first on Q1 2019 core gross margin guidance down roughly 100 basis points. Can you quantify the impact of negative price cost for us?
Ryan, are you talking about our guide?
Yes, the guide for Q1 of 2019.
To be honest, not yet. We'll do it after the given that look, it's still moving. We generally like to wait till the quarter before we give you price cost.
Okay.
So look, it'll be slightly as Rustom said, what's happening, Ryan, and maybe just would it be helpful just to talk about just step back and talk about the margin dynamic of what we see happening right now?
Well, I think it would, especially in the context that you got a 1.5 increase in the big book, yet you're negative on price cost. So maybe just explain all that.
Yes. So really just to be clear, price realization has been fine. So based on the price increase, what you're seeing and I'm sure what you're reacting to is from Q4 to Q1, you're seeing a sequential movement of a minus 20 basis points, whereas typically you'd expect to see flat to up from us. Price realization is fine and it's been solid. What you're seeing is 3 things going on.
One is, as Rustom mentioned, purchase cost escalating. And this is the timing issue that we generally have when these are going back to the start of calendar 2018 when the costs come in and we get pricing ahead of cost. 2 is we have a handful of national accounts that are lower margin national accounts that happen to be growing robustly and are creating a bit of a mix issue within national accounts for the moment. And then the third issue is web pricing, which slight and I say slight headwind to gross margin, but of course is helping fuel growth in the small accounts, which over time we see as a tailwind actually. But that's what's going on.
So the price realization, getting pricing in has been fine. It's those three factors that are accounting for the 20 basis points.
Okay. And then to follow-up, 2019 framework, you have scenarios where gross margins expand year over year. So what would you need to assume for that to happen? Obviously, you need to put through a mid year. Do you also need to assume that mix is positive?
So the core outgrows national accounts, is that a possible outcome?
So Ryan, fundamentally, it's pricing, right? I mean pricing would be the big one. So broad based inflation with us putting through price increases. Now with mix, I mean, yes, the core businesses has been doing much better and the core businesses inherently profitable there. And so mix would be a factor, but the fundamental is pricing.
Ryan, one point to clarify on the framework and Rustom hit this in the prepared remarks. I just want to make it clear. So the midpoint of that
a little
different from last year. The midpoint of that framework, if you go on the vertical gross margin access, so if you go to last year's and let's take AIS out and talk base business. If you go to last year fiscal 20 eighteen's gross margin for the year, it averaged 43.7 percent. The midpoint of that line is not 43.7 percent, it's 43.3 We chose 43.3 because it is the most recent data point we have our Q1 guide. But in other words, to get to that top half of the framework, we don't need to be above last year's average.
We need to be above Q1's 43.3. And if you look back in time, look, you see some years where from Q1, it just margins just drift down. Those are typically years where there's no pricing and kind of the headwinds in the business go down. But you'll see other years where gross margins and a couple of years back, where from Q1 gross margins are flat or even up a bit and those would particularly be in years where there's a solid mid year. So I just wanted to make that point that it's not off of last year's average, it's off of Q1.
That's the first time that we provided gross margin on the y axis. And so we decided looking at that, that better to go off where we are seeing ourselves running currently versus going off last year's number. You could do one or the other. We just happen to choose that.
Got it. Okay. And just lastly, you mentioned general inflation could help your gross margins in 'nineteen. And I think you're one of the only distributors I've heard so far say that tariffs, I guess, indirectly could help your gross margin. So can you just explain how this works exactly?
Because it feels like achieving positive price cost is tougher these days just given transparency.
So Ryan, here's the dynamic and what I would split out is direct what we characterize as direct versus indirect. And I think on the direct and I think one of the things is the company MSC has a relatively low percentage compared to other distributors of direct China sourcing, right, at around we said around 5% of total. And I think there the difference is in that case, we're paying the tariff. In that case, I think you're right. I think it's a challenge and sort of best case is you get all of the tariff through, which is what we're going to aim to do.
And best case is it's a net neutral, right. The other side is where there are branded industry suppliers who in most cases in some but not all of their product line is coming from China. And while they're realizing tariffs, unlikely that these companies are going to go along and take to market a 25% increase that more likely in discussions that we're having with many industry partners, what we're likely to see is that gets blended in and that gets blended in the form of an industry increase. If that's the case, it's really not all that much different from when we see a normal list price increase from a manufacturer except that the amount could be bigger And I think there'll be more air cover around price utilization. Our customers, our suppliers, everybody acknowledges that input costs are going up.
So that's the difference between the direct and the indirect.
Just one point to add there. We can also address sourcing just like suppliers, just like suppliers will and particularly exclusive brands or the rest we can offer our customers alternative products are not affected, work on our supply chains, all the rest of that. So it is still early days and then the biggest part, the tariffs are I guess not due to kick in for another couple more but there's multiple ways to address that.
Our next question comes from David Manthey from Baird. Please go ahead with your question.
Hi, good morning guys. Hi, David. First off, Eric, can you outline what specific changes were made with sales force effectiveness? Why they had such a negative impact on your growth and what are the key factors that are expected to drive productivity in the coming year?
Yes, sure, Dave. So looking back on the last year, as I mentioned in the prepared remarks, I mean, to put very simply, if I had to describe our old sales our old our prior sales model, which was really tied to a spot buy value proposition, it was more of a one size fits all model, meaning that we would hire the same profile of sales rep and that sales rep would have accounts on his or her portfolio that would span the range of lifecycle with MSC, meaning brand new accounts all the way to highly penetrated complex accounts on the same portfolio. The fundamental gist of the changes was to cluster and segment out our sales force so that we have a few different roles tied to specific different types of accounts, so there's more focus. At its simplest level, that was the change made. It was a lot of disruption last year, Dave, because what we had to do to make that happen to get from where we were to where we are is there was movement of people into new roles.
There was movement of salespeople across customer relationships. And as we went through these changes, our Head of Sales rightfully called out and said, hey, I've got to slow down. I've got to take sales headcount down because we were hiring into an old selling model, which would not have made sense. So we took a pause on hiring to as we segmented, so sales headcount came down, which was sort of a double whammy on top of the disruption. We are now on the other side of it.
And I would say we are starting to find our sea legs and see the kind of progress that the pilot test market would suggest. So we had a pilot market here before we put the whole sales force through this. That pilot market took a couple of quarters, I would say, to settle in and then took a couple of quarters for it to reach double digit growth. So if I what we do is we track that pilot market's progression against the company. The company in Q1 is right on track, particularly and look, the issues in government that I just mentioned earlier are muting what is pretty solid progress in specific areas such as the core, which is really where the bulk of these changes were aimed at the core.
And so we're encouraged there.
Okay. Thanks for clarifying. In Rustom, second question is on expected contribution and pull through margins. The framework seems to imply at the midpoint full year contribution margin close to 20% and pull through around 40%, if I'm calculating it right. But the midpoint guidance in the Q1 is much lower than that.
I'm just wondering what do we have to bet on to believe that the remainder of the year in terms of read through margins are going to be better than what we've seen or that what we're going to see in the Q1?
So Dave, one quick point here. I mean, 1st of all, it's a quarter and quarters do move around. I mean, we've had quarters in the past who've been almost 30%. And I said, hey, don't walk away thinking it's 30. It's an annual framework and you kind of run annually.
Actually, if you also look back at last year's Q1, just interest, I mean, that was again, it was probably around 10%, I think, from memory, the incremental margin in Q1 of last year. So take the quarter factor out of there. So really, so how do we deliver that 20%? I mean, first of all, we are constantly driving productivity. Our OpEx to sales has improved 180 basis points over the last 3 years.
We're driving functional productivity. We're reducing our cost to serve. And yes, in 2019, we're going to see the cost impact in Q1 as it comes in, in particular of the increased investments in sales and service headcount. We're continuing to do that and we're spending marketing as well, right. So we'll continue to see that.
I mean, that's the range there. But the other point that Eric made was really important. So I'm just going to repeat it. I mean, it's that if you look at those 20% type incremental margins, we don't have to actually expand our gross margin, provided there's decent sales, we've got to come in relatively close. We've got to come in relatively close to the gross margin, the midpoint, if you would, that we have in there, but we're not really looking for expansion per se.
So I mean, it's a combination of those factors as we go through the year. And I guess the final one, I'll just repeat that again because it's important, it's realized pricing. I mean, that's going to have be a huge determinant and the flow through that it has because we to quite an extent, we know what our costs are anyway at this point in time, certainly in the early months because we've got a lot of cost increases that have come through. Others will happen, but as those costs increases occur, it takes its lag just like in our business, the average pricing, the fact that we buy ahead, all the rest of it. So the cost increases that come through to us later this year will take a while to work their way through our P and L.
So pricing is huge as well. Eric, anything to add?
I think that was pretty comprehensive. The only thing I'll add, Dave, is that the OpEx, so with respect to OpEx, there's a step up from Q4 to Q1. There's a bit of it in there that doesn't repeat. But then the other part of the step up is growth investments. And if we look out across the balance of the year, it's not like OpEx goes down.
So OpEx goes up modestly through the year, but OpEx as a percentage of sales, assuming we do on the revenues, what we'd expect to do on the revenues, OpEx as a percentage of sales comes down. So we actually do get leverage as we move through the year. That's the plan.
Yes. Okay. All right. Thanks guys. See you next week.
Yes. Take care, Dave. Thank you, Ben.
Our next question comes from Ryan Cieslak from Northcoast Research. Please go ahead with your question.
Can you
hear me?
Now we can, Ryan.
Okay, great. Sorry about that. Yes, so I just wanted to make sure I understand maybe the impact from this loss of government contracts on the Q1 organic sales guidance you guys are giving as well as the framework for the full year. Can you quantify ultimately how much of an impact that's going to be dragging on organic sales?
Yes. So, look, in Q1, Ryan, just without getting too specific for competitive sensitivity, you could get a sense. So we had a step down from mid single digits and then we talked about mid teens. What I'd tell you is not all of that. There's a portion of that that is a change in year end spend activity year on year.
But a decent portion of that is the headwind from the losses. I mentioned that a headwind will likely continue for the next couple of quarters. But look, there's a lot of countermeasures going on, number 1. So there's a decent chance that the headwind moderates from where it is in Q1. And sort of zooming out and looking big picture here, what I've been talking about Ryan is the expectation that the business should be performing in the high single digits and that we would expect as we move through the year that it wouldn't get there over night, but that we would see improvement and that we'd be able to get there.
And look, there are a lot of tailwinds that I see with the ability to offset this headwind and still get there. So those are look, we're just settling into the new sales changes. We're making sales hires that are not yet having an impact. We added new SKUs that are just starting to have an impact. Rustom mentioned we've increased direct marketing investment because of the performance of the small accounts.
We see momentum building there. So there's other tailwinds that have me pretty encouraged. Okay.
And just to be clear, they rolled off at the end of last quarter, was it are they fully reflected rolled off in the September number and October numbers you guys gave? Just want to make sure.
They're fully reflected in Q1.
Okay, got you. Because when I look at the October sales, it looked like when you look at it on a 2 year stack trend or you take into account the comps were easier in October that the growth rate seemed like it moderated a little bit. Is some of that from these government contracts or is there anything else, Eric, that you'd point out of maybe how things are looking in the last 30 days or so within the environment and overall demand? Has anything changed significantly?
No, Ryan. I would say environment seems solid and progress again on the core accounts, the small accounts, kind of the bread and butter of the business, if anything, is doing better. So just take mid teens and say government ballpark 10% of sales and say hypothetically, if it were just flat, what does that mean to the overall growth? Now obviously, look, we own it all. But my point is with the bread and butter of the business here, I'm encouraged that the sales changes that we made last year are starting to take hold.
So nothing else I'd note in the environment or other parts of the business, no.
Okay. And then for my follow-up, and I'll get back in the queue. I was a little surprised that right now you guys are sort of facing price cost headwinds. And I get the lag in realizing the cost and but it seems like just on the surface that price realization maybe has fallen below what you were expecting. At least that's how it comes off.
I just wanted to maybe, Eric, get a sense of why would your price cost dynamics actually improve into next year based on what we've seen so far here year to date, certainly considering it's been a strong environment, supply chain is tight, lead times are extending. If you weren't able to really sort of maybe offset some of these cost headwinds that have rolled in this quarter, why or how can you offset that and maybe get some more into fiscal 2019? Thanks.
So one quick point before Eric comes in there. I mean, if you just say Q4 as a guide, I mean, our price mix, the realization as we call it there was 0.5% rounded to 0.5%. So I mean, we continue to see price realization. Ryan, the really important point with the of what you see with our costs is we moved, we took a price increase back in I think it was July, right? And we've had cost increases come through.
Some of those cost increases we actually deferred the impact of by pre buying, okay. And with some of those and with all of them in any case with the way the average costing system works, it takes a while for them to actually start showing up in our P and L. That's what's behind my other point. For several months out, we've got a pretty good sense of provided our sales mix remains relatively the same, we've got a pretty good sense of how our costs will trend. Eric?
Yes. Only thing to add there, Ryan, is in an inflationary cycle and Rustom described the dynamic as to why, what typically happens is, again, as I always say, the trigger for us is, other than the tariff situation, is manufacturer list price movement and that gives us the opportunity to pass along pricing. We take a timing benefit where we get we realize price ahead of cost primarily because of the average costing system that Rustom mentioned and you saw that from us. So if you go back to a couple of quarters ago, we had a couple of quarters there where price turned from negative to positive and costs were still in the flat range and that created positive variance. Over time, what happens is the costs work their way through our P and L.
And in an inflationary cycle, what then happens is there's a next round of pricing and we get another benefit and then the costs catch up, etcetera, etcetera. So that's basically what you're seeing here. Look, our summer increase here at 1.5% was not as big as I would have thought given the headlines. But the opportunity, hopefully this is temporary and specifically temporary if the tariffs stimulate manufacturers to move as we suggest. That's really the story.
Tania, back to me
for a second. I mean, we're pretty focused on gross margin stability, if you think about it. I mean, the want to make sure it doesn't get lost in this.
If you
look at our base business over fiscal 2018, right, our gross margins for the year are pretty much in line with 2017. I mean, I think in this environment, that's actually been not too bad at all. And that gets achieved by a bunch of discipline in how we approach business. I mean, a focus on makes, a focus on customer profitability. That's the gross margin end of it.
So cost to serve doesn't impact that, but we also spend a lot of time and efforts on cost to serve that shows up in our productivity and helps us in our operating margins. So I just want to make sure that was out there as well as we focus on Q1, how we've done in 2018.
No, that's fair and I appreciate the color. I just want to be clear though. So there's nothing that you think, Eric, that is impacting your ability to get price today, maybe related to some of these sales force initiatives. And certainly, there's been a balance between top line growth and margin. But as you move forward, as this is now behind you with the sales force initiatives, you have some new guys coming in.
That should not impact your ability ultimately to continue to get price and offset these costs that are rolling through? Thanks.
No, Ryan. The only other two factors I'll call the answer is no, it shouldn't. The new sales model should not impact our ability to get price. The only two other factors that I mentioned in the gross margin while Q4 to Q1 beyond the purchase costs that we talked about were 1, national accounts. So we did have a handful of accounts that are lower margin accounts that grew a lot, okay.
2 is web pricing, which we've been working on and we talked about it in the last couple of quarters, which is a slight it's not a major needle mover, a slight headwind. But a slight headwind near term, it is helping to fuel the growth in the small accounts that we've been talking about, the direct marketing channel, which if that continues, actually over time becomes a tailwind for us. But those are the only 2 other factors I'd call out.
Okay. Thanks guys.
And our final question today comes from Steve Barger from Key Bank Capital Markets. Please go ahead with your question.
Good morning, guys. This is Ryan Mills on for Steve.
Hey, Ryan.
Yes. My first question, you added 35 field reps this quarter. And Eric, I believe you said you're going to add 50 more by the end of the year. Can you maybe talk about the impact on your operating margin framework in regards to that? Because I assume there's a fixed cost component tied to that where you start them as a salary and then transition them on a commission based pay structure.
So is there any impact to your operating margin framework from adding field reps?
So let me take that actually. It's already built in there. Yes, it does add to our costs. And the way this works is the like the people that we hired in Q4 for the most part, they kind of come in during Q4, they fully obviously hit for all of Q1, right? Like that for the remaining 50 or whatever number it is that we actually bring on board and the service people you have that factored through.
But all of that is already factored into our sort of plans for the year and our operating margin framework. Now one of the points that we made and we made it in prior calls and remember is that the sales impact of this, so when you hire, there's always a lag when you bring in field sales people, there's always a lag before they actually start to drive enough sales to pay for themselves and then start to really do well. So we've assumed that the hiring that we've started with at the end of Q4 and that's ongoing today, it's not really going to show up too much in our revenue until the latter part of fiscal 'eighteen or fiscal 'nineteen and then of course definitely in fiscal 'twenty, right. So all this stuff by the way is factored into the op margin framework.
Okay. And then going to your September October trends, I know you called out government as a headwind. Sorry if I missed this in your prepared remarks, but were there any impacts that you could point out from hurricanes?
Minor. Yes, it's a good question, Ryan. Yes, I mean, look, there was probably it gets really tricky to try to quantify it. So we didn't bother. Look, there's probably some headwind in September and October, to be honest, but we didn't make too much of it.
Okay. And then my last question, you re accelerated your SKU count growth. Can you talk about the decision making process there? Is it more focused on high turnover products or higher margin products?
So we will generally look at new so the new SKU program, which has been you can see our SKU count has been growing for quite a while. We are generally it's a pretty data driven process where we are looking at products that are selling in the market that customers are requesting that we may be sourcing ad hoc and looking to bring those in and create a more formal marketing program around them. We'll look in terms of financial criteria, we look across a number of metrics. Primarily, we're looking at returns on capital. These tend to be efficient ways to add products because we will market them and bring them into inventory only after we see line of sight into revenue.
Of course, we'll look at margins, but primarily return on capital and tend to be very strong. So what we did in the Q4 by the way is we saw an opportunity where we saw some recent success in certain pockets and we just we hit the accelerator. So there was some Q4 expense, a little trickle over expense into Q1 that doesn't repeat, not that much. And from there, beginning this quarter, there's a little bit of contribution in Q1 and you imagine it builds over time as we move through the year.
Thanks for taking my questions.
Thank you, Ryan.
And ladies and gentlemen, at this time that will conclude today's question and answer session. I'd like to turn the conference call back over to Mr. Corona for any closing remarks.
Thank you, Jamie, and thanks everyone for joining us today. We'll be on the road over the next coming months before the holidays attending some conferences and roadshows. We look forward to seeing you out there. And if not, we'll report our next earnings on January 9, 2019. Have a good day.
Ladies and gentlemen, that does conclude today's conference call. We do thank you for attending today's presentation. You may now disconnect your lines.